So many articles have been written recently about Apple (AAPL) — defending it or explaining why this glorious fruit will turn into a shriveling pumpkin by midnight (with Samsung’s help) — that I really haven’t felt the need to contribute to the unending debate. But then Apple’s stock crashed to $450 last month, and we bought a little for our clients. After receiving an outraged e-mail from one of them calling the purchase “irresponsible” and proclaiming that everyone (including his neighbor) knows that Apple is going down to $300, I decided it was time to join the discourse. Clients rarely (almost never) contact us about stocks we own in their accounts. More important, this is far from the most “radioactive” stock we own or have owned.

Here, in the first of two columns on Apple, I have no intention of defending or prosecuting the company, but I would like to share some thoughts about it that many pundits have either overlooked or ignored.

What makes Apple stock difficult to own is psychology. The company’s success since 2000 is a black swan. We tend to think of Nassim Nicholas Taleb’s black swans as significant random negative events, but Apple is a positive one. When co-founder Steve Jobs came back to the company in the late ’90s, Apple was about to take its last breath. Jobs pulled off a miracle. He revived the company’s computer product line, making Macs exciting again, and then came out with three revolutionary “i” products in a row: the iPod, iPhone and iPad. You could argue that the success of each “i” product in itself was a black swan, exceeding all rational expectations and revolutionizing, transforming and in some cases creating new categories of merchandise that had never existed before.

Apple’s revenue and market capitalization deservedly surpassed those of almighty Microsoft Corp. — the hairy monster with stinky breath that performed CPR on dying Apple in the late ’90s by injecting liquidity into the company by buying its preferred stock. We have a hard time processing this highly improbable success and an even harder time imagining that there is another black swan about to take flight from the Apple labs, especially with no Steve Jobs around to sit on the egg.

Black swans come out of nowhere, unannounced, but their impact may be long-lasting. The wildly successful “i” gadgets dug a formidable moat around Apple.They created the most valuable and still most inspirational brand in the world, funded an enormous research and development effort, enabled huge buying power (Apple locks up supply and pays much lower prices than many of its competitors for parts), filled out a mature product ecosystem and stuffed Apple’s debt-free balance sheet with $137 billion — half the market capitalization of Microsoft. The moat is wide, deep and unlikely to be breached any time soon.

One reason the psychology of owning Apple stock is so difficult: its high price.(Note: I am talking not about its valuation but purely about its price.) Apple has had only one stock split since the late ’90s, when it was trading in double digits, and it now changes hands at about $450 (down from $700 just a few months ago). Stock splits create zero economic value in the long run — absolutely none.Apple could split its stock ten to one and you’d have ten $45 shares, and nothing about the company or its business would change. But I’d argue that a 3 percent “slide” of $1.35 would grab fewer headlines than a $13.50 “drop” — there is a media magnification factor that is hard to ignore.

Is Apple a hardware or a software company? This is a very important question because Apple’s net margins of 25 percent are dangerously higher than those of Microsoft, a software monopoly that, with the minor exception of the Xbox and its new venture into tablets, sells only software, which has a 100 percent incremental margin.

Apple is either a smart hardware company or a software maker dressed in hardware company clothes. Take a look at the PC businesses of traditional “dumb” hardware companies like Dell and Hewlett-Packard Co. (I am not insulting these companies, I am just highlighting their lack of PC-directed R&D.) They buy hard drives from Western Digital Corp., graphic cards from Nvidia Corp., processors from Intel Corp. and an operating system from Microsoft, then they have contract manufacturers put together these parts in Asia and ship PCs all over the world. Dell and HP engineers design the PCs but contribute minimal R&D to their boxes; most of the R&D is done by the suppliers. Dell and HP are really asset-lite marketing and logistics companies — this explains their razor-thin margins. (Side note: Because of a lack of fixed costs, Dell and HP can remain profitable despite the ongoing decline in PC sales.)

On the surface, Apple’s personal computer business is not that much different from Dell’s or HP’s: It uses the same highly commoditized hardware and it also outsources manufacturing, but Apple spends much more on the R&D of its own operating system and creates distinctive, innovative products. Apple gets to keep a slice of revenue that would otherwise go to Microsoft for the operating system.Also, Apple is able to charge a premium (usually a few hundred dollars per PC) for the aesthetic appeal and perceived ease of use of its products.

However, when it comes to the “i” devices, Apple is a much smarter hardware company; its value added goes further than just basic design and software.Though there is a lot of commoditized hardware that goes into an iPhone or iPad, Apple’s skill at fitting an ever-growing number of components into ever-shrinking devices constantly increases. Add world-class touch and feel, superior battery life and durability, and you have a package that turns what would otherwise be commodity items into highly differentiated, and undeniably sexy, products. Apple has even gone a step further and is designing its own microprocessors.

But — and this is a very important “but” — as phones and tablets mature, processor speed, battery life and weight will tend to become uniform across all devices. It is arguable that the competition has already caught up with Apple in the hardware race. As the hardware premium goes away, there will be only two premiums left: Apple’s brand and its ecosystem. (I will go into detail about the “i” ecosystem and what it means for Apple’s margins and profitability in my second column, later this week.)

Note that I did not mention the software premium. Unlike Microsoft, which charges for the Windows operating system installed on PCs, Google gives away Android to anyone who dares to make a phone or a tablet. Unless Apple can maintain the operating system lead against Android, that premium will go away.Recently, I spent a few days playing with Nexus 7, Google’s Android-powered 7-inch tablet, which retails for $200 ($130 cheaper than Apple’s iPad mini). Nexus 7 is a good product, but I kept remembering that humans and monkeys share 98 percent of their DNA, and the Android operating system is missing the 2 percent that makes Apple iOS so special.

Next: I’ll explore the competitive advantage of the Apple ecosystem, insult some of its competitors and analyze what the company’s shares could be worth under different scenarios.

About the author:

Vitaliy Katsenelson

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email or read his articles click here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy’s book Active Value Investing (Wiley, 2007).

Comments

Thanks for stepping back and looking at Apple stock rationally. It surprises me how many people have run away from Apple in the recent months. But then, that's when the smart ones move in. I bought Apple when Microsoft was bailing them out (late 90s). I'm soooo glad I did.

think that if it was a positive black swan it may be a negative one since today.The reality is that nobody knows it, it's too unpredictable business.But we can say that now it 'is a value sotck, conisderaing brand, cash, and culture.

Their product portfolio has grown and, like any other industry leader, has attracted imitators and innovators alike. What sets them apart, however, is creativity backed by the highest investment in R&D of anyone in the industry - software or hardware. They are a new product machine that seeks to transform mega industries including home entertainment, interpersonal communications and, eventually, the auto dashboard. Imagine a docking sleve for an iPad mini, right in the center stack, controlling just about everything a car does and including web access. The manufacturer who cuts a deal with Apple will hit the jackpot, as will AAPL shareholders.

If they are judged on their current product portfolio, expect margins to shrink and competitors to catch up. If history is any indication, such a focus will miss the genius that is Apple. And so I'm long at 450.

^ the next decade. Your standard of measure may distort your intrinsic value measurement. It's definitely a company with a short product life cycle, and hence a potentially short corporate life-cycle. So, one's recognition of value stocks in that environment must be commensurate to the intrinsic nature of the underlying business model.

Apple is a great company and true innovator, however it is not an Extraordinary company. What is the difference? Well I think about what Warren Buffett refers to the 3 i's of a business or industry, and how it relates to Apple.

The first I stands for "Innovator". This is the person or company that sees a need or opportunity and fills it. Because this need was previously not being met the "profit" from it is tremendous. So Apple creates the i-phone. This phone does more than any other phone can do at the time it comes out and consumers and business people grab it as fast as they can get it. The second I stands for "Imatator". Yes, those news stories showing people waiting outside of Apple stores trying to get the latest version of the i-phone was not lost on competitors like Microsoft, Nokia, Dell, Google, Samsung, Sony, HP and every other consumer electronic manufacturer. Those profits are pretty alluring and it brings competition for Apple. Competition will bring down profit margins as competitors will relentlessly work to gain some market share from Apple. Apple did not invent the phone and the tablet is basically a larger version of the phone. They do not have a "Patent" or other huge barrier that prevents others from competing with them. THe last I is for "Idiots". This is the last companies that are still piling into a market that is becoming more and more competive. The competition is and will drive the prices down, down and down. How much does a 60" plasma TV cost today versus five years ago? Apple can not stop the other companies and its dominance is related to "first mover advantage" rather than a more durable moat like a "patent". A great company has a great run of success, but an extraordinary company has a durable competivie moat that keeps it on top for decades of time.

What is the appropriate valuation for Apple? Well, I would use Ben Graham's process of determining normailized earnings as a foundation for determining it. I would look back 10-YEARS at Apple's earnings and take the average of those earnings and consider that as "normailized earnings" for Apple. It is up to you to put the appropriate multiple for you on those earnings, but those earnings are a lot less than the earnings Apple is currently showing investors. Am I too pessimistic that Apple's normailized earnings could be less than half its current earnings? Well, the cash hoard that Apple keeps and won't distribute says that I am not the only one!

That brings up another question, what should Apple do with its cash? Well, I have a crazy idea. Invest it in an "extraodrinary" company that is in its same industry, increases its return on the cash, high credit quality, at a price that offers a margin of safety and potnetial for above average total returns going forward and has liquidity. What could that be? Well, wait for it- Microsoft!!! What? Yes, Microsoft. If there was ever a competitor to Apple it would be Microsoft. I know there are people for personal belief don't like Microsoft for they have been the dominant company in technology for decades. Microsoft is the dominant and ingrained and embedded technology company. As I have said time and time again, there is an old saying regarding coporate Chief Technology Officers "You dn't get fired for hiring IBM!". IBM is not recommending that people go to Apple and make Apple a platform company like Microsoft has been and is today.

Microsoft has a cash hoard that they are buying back stock and increasing dividends. Their share buy back is based upon a stock that has a depressed P/E multile and normailzed earnings. THe company sells at nearly a 30% discount to the S&P 500 and pays around 3.4% or nearly 1.7 times the 10-year Treasury bond. Apple can't buy Microsoft stock! Why? The cash they hold earns shareholders less than 1% in nominal returns and in real return terms is losing investors money in terms of purchasing power. Microsoft is going to benefit from all the other companies competing with Apple and it will still have its core business. Microsoft is anextraordinary company and Apple could get some of that by buying a nice piece of Microsoft!

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